Tuesday, 16 October 2012

One head is better than many

Indian Express, 16th Oct 2012

A single financial regulator, rather than sectoral ones, is what
India needs

The Union cabinet recently approved two bills expanding the powers
of relatively small financial sector regulators. The PFRDA bill and
the FCRA Amendment bill, if passed by Parliament, would give statutory
powers and greater teeth to the pensions regulator and the commodity
futures regulator. Though this may appear to be a reformist move in
the current context, it could create difficulties for longer term
financial sector regulatory reform.

These two bills were first proposed before the government set up a
slew of expert groups to examine financial regulation in India. Almost
all these committees suggested that all non-banking financial
regulation, at least, be brought under a single regulator. They argued
from Indian and international experience that it is becoming
increasingly difficult to effectively regulate modern financial firms
through a sectoral approach.

It seems unlikely that the cabinet is turning down these expert
recommendations, including those from a group chaired by its present
chief economic advisor, Raghuram Rajan. It is more likely that in its
attempt to fast-track reforms, it has approved all the financial
sector and economy bills that had been placed in limbo, without
re-examining them carefully in this post-global-crisis world.

The expert groups, including the Mistry, Rajan, Aziz and Sinha
committees, have examined the role and function of various regulators
and suggested that they be modified to remove the various conflicts of
interest, regulatory overlaps and gaps that plague the system
today. They also raise questions about economies of scale in the
regulation of organised financial trading. At present, regulatory
functions on organised financial trading are spread across SEBI, RBI
and the Forward Markets Commission (FMC). This separation between
multiple regulators has forced an inefficient partitioning within
private firms too: for example, a brokerage firm operating on the
stock market where it faces SEBI regulation is forced to create a
separate subsidiary to trade on commodity futures markets with FMC
regulation and a separate subsidiary to be a primary dealer, which
involves an engagement with the RBI.

Given the nature of organised financial trading, there could be
economies of scale and scope for both government and the private
sector through unification of regulation of organised financial
trading. This requires pulling together the functions related to the
bond and currency market from the RBI, functions related to the stock
market from SEBI and functions related to commodity futures markets
from the FMC, and merging these into a single agency.

Further, the Indian financial system has changed from one almost
entirely dominated by public sector firms to an incipient role for
private and foreign firms, which has helped bring a substantial rise
in the sophistication of the firms. This has given rise to large,
complex financial institutions such as the ICICI and HDFC, which serve
households and firms across all aspects of financial services. At the
same time, these firms have chosen to organise themselves through a
large number of sectoral financial firms, each of which fits the
requirements of one financial regulator. But no single sectoral
regulator gets a full picture of the risks in such large
conglomerates.

The recent cabinet approvals may have consequences similar to the
RBI Amendment Act of 2006, which established the RBI as a regulator of
the bond market and the currency market. This was a step in the wrong
direction, given India's reform agenda on the regulation and
supervision of securities markets. In all the OECD countries but one,
a single government agency - the securities regulator or the unified
financial regulator - deals with all aspects of organised financial
trading. In the US, the treatment of organised financial trading is
split between the CFTC, which deals with all derivatives, and the SEC,
which deals with the spot market. Apart from this, the OECD practice
involves a single agency that regulates all organised financial
trading, with a unified treatment of equities, commodity futures,
interest rate, currencies, corporate bonds and derivatives.

This mistake led to serious consequences for the bond market. In
the equity market, the strategy for critical financial infrastructure,
exchanges, clearing corporations and depositories, was based on three
principles. First, there was a three-way separation between
shareholders, the management team and the member financial
firms. Second, there was a competitive framework. Third, the
regulator, SEBI, did not own critical financial infrastructure.

None of these three principles was applied to the bond market. The
critical bond market infrastructure involved a depository (the SGL)
and an exchange (NDS) both owned and operated by the RBI. This was a
problematic arrangement because the RBI had conflicts of interest by
virtue of being an owner and service provider, and at the same time,
the regulator (after the enactment of the RBI Amendment Act of
2006). There was a loss of competitive dynamism when the RBI's policy
decisions leaned in favour of blocking competition against NDS and
SGL. Only financial firms regulated by the RBI, the banks and the
primary dealers were allowed to tap into this infrastructure. This
framework was thus unable achieve bond market liquidity. On paper,
India has an impressive bond market with trading screens, a clearing
corporation, etc. But the essence of a market is liquidity,
speculative views, and the resilience of liquidity. None of these is
found in the Indian bond market.

The Indian discussion on the role and function of government
agencies in financial regulation needs to be examined in the context
of the difficulties of staffing high quality agencies. Even when an
agency starts with a clean slate, without institutional baggage from a
pre-reforms India, without conflicts of interest and archiac legal
foundations, without expert staff, there is still a substantial risk
of failure in institution building.

In India, there are many delays in processing legislations. At
every stage, the government should be checking back whether it still
want to propose a certain legislation. A little more thought in 2005
would have prevented the RBI Amendment Act of 2006, and a little more
thought today will prevent mistakes on FMC and PFRDA. The government
already has the benefit of the views and recommendations of various
expert committees, which have studied the issue in detail and set the
direction of long-term financial sector reform. Government policies
policies in the short run should fit with its long term goals.